Farr: Reflections on the 3Q
Throughout the financial crisis of 2008 and the market lows of 2009 we have suggested that recovery would be a difficult and bumpy process.
Predictions of a V-shaped bottom seemed absurd based on all the available evidence. We hold to a rather simple view of economics. The US consumer represents about 70% of US GDP. Therefore, a strong US economy requires a strong US consumer. We have argued that the consumer is saddled with excessive debt, high unemployment rates, weak income growth, falling housing prices, inadequate retirement savings, and broad feelings of insecurity. These issues seem likely to weigh on the economy's growth potential for many more quarters if not years.
Yet despite these headwinds to recovery, we feel that the process of recovery has begun. Housing prices are much closer to bottoming and savings rates have increased. Despite continued reluctance to lend freely, banks have been recapitalized and their health is unquestionably better than 2-3 years ago. Low interest rates have allowed many homeowners to refinance, freeing up lots of discretionary income. Energy prices have come down, and higher stock prices have fueled strong increases in consumer spending (albeit mainly from wealthier consumers). Each of these factors has supported economic stabilization.
Unfortunately, the progress that seemed steady (if not robust) was sidetracked by the sovereign debt crisis in Europe. While the US still represents something less than a quarter of world GDP, the contribution from the European Union is even greater. The old adage "when America sneezes, the whole world catches a cold" can now be applied to Europe as well. In an increasingly interconnected world, Europe buys much of the products and services that US corporations produce. Moreover, world financial systems are inextricably linked such that a crisis in one region inevitably causes mayhem throughout the world.
The Greek problem is not a huge problem in and of itself. If the problem were contained it would be nothing more than a blip in the short history of the European Union. However, because of Greece's inclusion in the European monetary union, and because Greek debt is held by all of the major European and U.S. banks, Greece becomes a major problem. The markets are volatile due to the risk of contagion, and the root cause is too much debt within the developed economies.
The over-indebtedness of the developed economies is a long-term systemic problem. It is neither a shock nor should it come as a surprise. We know precisely the genesis and evolution of the problem. While definitive solutions remain evasive, it is becoming clear that the ultimate resolution will require a long period of time and a good deal of pain. Austerity measures designed to reduce debt burdens will slow economic growth. This will be the case in Europe as well as the US.
The performance and volatility of most all asset classes, including stocks, bonds, currencies and commodities, are sending the same clear and striking message: global economic growth expectations are far too high. The most glaring examples are the US dollar and US Treasuries. In spite of our own turbulent economic problems, including a tumultuous budget battle reflecting surging anxiety over our own debt levels, the dollar and U.S. Treasury bonds rallied strongly during the quarter. This is because the US is still viewed as a safe haven for anxious global investors.
Hey, at least we can still say we're still the best house in a bad neighborhood.
"Our View"
In the face of such dramatic uncertainty and volatility, this is not the type of environment in which it makes sense to "swing for the fences." We simply believe there is little reason to accept undue risk at this time.
Economic uncertainty is high, and relative valuations for high-quality US corporations with global operations are as compelling as they have ever been. Companies like Johnson & Johnson and PepsiCo have limited amounts of debt, excellent cash flow, strong earnings, experienced management, good dividends and, perhaps most importantly, very rational valuations. We know that valuations can certainly go lower in the face of unprecedented global uncertainty. However, we also believe that the risk/reward proposition is looking increasing compelling in a world of 2% long-term Treasury yields.
So we will maintain our cautious and defensive course.
Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years and is the author of "The Arrogance Cycle."